Week 1 Currency Systems and Crises

Definition An exchange rate is the amount of currency that one needs in order to buy one unit of another currency, or the amount of currency that one receive when selling one unit of another currency.

Exchange Rates Today 1. Exchange rates are volatile. –If the exchange rate floats, the value of the rate fluctuates daily. –When the exchange rate is fixed or pegged, it does not fluctuate daily, but can change dramatically if the peg is broken. 2. Booms and Busts: Exchange rate systems are subject to currency crises. –The Asian currency crisis of October 1997 –Argentina in 2002.

Exchange Rates Today 3. Despite much effort, exchange rates have proven to be very difficult to predict or control. –Historically, almost all nations have sought to exert control over their exchange rates - but with very limited success. 4. Exchange rate fluctuations can have substantial impact on the real economy. –The Asian crisis had a substantial impact on the domestic economies of the countries that were affected. In the case of Indonesia, it also had an impact on the political environment, resulting in the resignation of Indonesia’s President Suharto.

Questions Every nation has a choice to choose a specific type of exchange rate system. What has been our historical experience with exchange rate systems? Why is the choice of an exchange rate system important? What are the advantages and disadvantages of each system?

Exchange Rate Systems Over The Times 1. Gold Standard –Value of currency is fixed in terms of gold. The gold standard was popular before the WW1. –Now only of historical interest. 2. Fixed/Pegged: against a single currency, or a basket of currencies (Thai baht before 10/97 currency crisis, Chinese renminbi) 3. Free Floating: US$, Japanese Yen, Euro, BP 4. Hybrid Systems: e.g.,Managed Floating: floating with interventions (for example, with target zones, or crawling adjustments) Brazil before January, Currency Board:Fixed exchange rate, with foreign reserves sufficient to support 100% of currency (Argentina until 1/2002, HK, Estonia and Lithuania). Our focus will be mainly on the Fixed, Floating and Currency Boards.

A Quick Look at History 1. US and Europe exchange rate and monetary systems – 1879 to today. 2. Recent Currency Crises

The Gold Standard: (1/11) 1. The official gold price was fixed (“mint parity”), with free convertibility between domestic money and gold. US adopted standard in 1879 and defined the US$ as fine grains of gold, or US$ 20.67/ounce of gold. 2. All national currency is backed by gold, and growth in money supply is lined to gold reserves. 3. As each separate currency was convertible into gold at a fixed price, the exchange rate between the two currencies was automatically fixed. 4. There is no fluctuation in the exchange rate unless either country changes the local price of gold.

Between WW1 and WW2 and the Great Depression (2/11) Countries experimented with floating rates in the 1920’s and ‘30, and this was widely thought to be a failure. Here’s a view from Ragnar Nurske (1944) of the League of Nations: “If there is anything that the inter-war experience has clearly demonstrated, it is that currency exchanges cannot be left free to fluctuate from day- to-day under the influence of demand and supply. If currencies are left to fluctuate, “speculation” is likely to play havoc with the exchange rate.” This view was remarkably prescient.

Bretton Woods Agreement: 1945 (3/12) 1. Fix an official par value of the currency in terms of gold, or a currency tied to gold. 2. In the short run, the exchange rate should be pegged within 1% of par value, but in the long run leave open the option to adjust the par value unilaterally. 3. Permit free convertibility for current account transactions, but use capital controls to limit currency speculation.

Fixed-Rate Dollar Standard: (4/11) 1. US maintained a gold standard at $35/ounce. 2. All other countries fixed an official par value in terms of the US$, and tried to keep their currency within 1% of par value.

Breakdown of Bretton Woods (5/11) By the late 1960’s, US liabilities abroad exceeded their gold reserves. US had run an expansionary monetary policy during the height of the Vietnam wars, and its current account and trade balance had deteriorated. It wasn’t possible for the US to back its commitment to its currency with gold. On August 15, 1971, Nixon officially took the US off the gold standard.

Floating Exchange Rates (6/11) By March 1973, all major currencies were allowed to float against each other. Rules of the Game: 1. Nations tried to smoothen short term variability without committing to an official par value. 2. Permit free convertibility for current account transactions, while trying to eliminate restrictions on flow of capital.

Floating Rates in the 70’s and 80’s (7/11) Within a few years, the major nations had eliminated restrictions on flow of capital, and, over time, the flow of capital became more important as a major determinant of short-term currency movements, than trade imbalances. Although, in principle, the exchange rate was to be determined by the market, policy-makers soon came to the conclusion that the “price” reflected by the exchange rate was either not warranted, or should be manipulated to better suit domestic economic policies. (Aside: This notion is quite contrary to our usual thinking of other “prices”, as, for example, stock prices.)

Interventions in the Currency Market (8/11) For the first decade, the US was passive towards the US$ exchange rate. But between , the US$ had appreciated by almost 50% in real terms. Plaza Accord of 1985: To counter the US$ appreciation, the G5 countries met at the Plaza hotel in NY and agree to intervene in a coordinated fashion to depreciate the US$. This agreement came to be known as the Plaza Accord. The accord worked and the US$ depreciated sharply through 1986 and This was the first major coordinated intervention.

Interventions in the Currency Market (9/11) By 1987, it was clear that the Plaza accord had worked well, and the currencies now needed to be stabilized around their current levels. Louvre Accord (Feb 22, 1987): At a meeting in Louvre, the G5 countries decided to set “target zones”, or exchange rate ranges, and the central banks agreed to defend their currency using active intervention.

European Monetary Union (10/11) European Monetary System: ECU, ERM and the Euro In December 1978, the European countries voted to establish a European Monetary System, with the ECU and ERM as some of its building blocks. 1. ECU: The European Currency Unit (ECU) was defined as a fixed amount of the national currencies of the member countries.

European Monetary Union (11/11) 2. ERM: The Exchange Rate Mechanism was the plan to limit exchange rate fluctuations. Each country that participated within the ERM agreed to limit the fluctuations to within 2.25 or 6 % (for UK, Italy, Spain and Portugal) of the rate defined in terms of the ECU. This narrow range proved hard to defend and it was widened to 15% after the ERM currency crisis of Euro: Common currency for the countries of the European Union introduced 1/1/1999. The ECU became the “Euro”. –Something to think about: Will UK join the Euro someday in the future? Will Switzerland?

Currency Crises Example 1: Asian Currency Crisis (Thailand, Indonesia, Malaysia, Korea, and others) Example 2: Brazil in Example 3: Argentina

Example 1: Asian Currency Crisis (October 1997) To date, the biggest post-war crisis in terms of its geographic reach and magnitude. All countries in the region experienced severe economic downturns.

Thai Baht vs US$ (Pegged before 10/97, and float afterwards)

Indonesian Rupiah vs US$ (Pegged before 10/97, float afterwards)

Example 2: Brazil’s Currency Crisis in Brazil (August 1998-January 1999): In defending its currency, Brazil lost more than $45 billion, and had to raise interest rates to over 40%. However, it could not stop the fall of the real, and ultimately decided to float the currency.

Brazil Real vs. US$ (Managed Float: before 1999 crisis)

Brazil Real vs. US$ (Free Float: after the 1999 monetary crisis)

Example 3: Argentina 2002 See attached WSJ articles about events on the crisis.

Argentine Peso vs US$ (Currency Board before 2002)

Argentine Peso vs US$ (2002)

Why is the choice of an exchange rate system important? 1. Because the exchange rate affects the price of traded goods, it directly affects domestic inflation and production. 2. Because the exchange rate system is tied in with the monetary system, it affects flexibility of domestic policy decisions (through money supply and interest rates). Thus, the exchange rates have a bearing on inflation, interest rates and, thus, the growth rate of the economy (consider the recent crisis in Argentina as an example).

Evaluating the Fixed/Pegged Exchange Rate System 1. Can create economic stability (get inflation under control, facilitate trade capital flows, gain credibility in reforms). 2. Reduces flexibility of both monetary and fiscal policy. The Central Bank’s mandate is to keep exchange rates stable. Thus, domestic economic policy has to play second fiddle to the objective of keeping the peg. Real exchange rate may not be stable even thought the nominal exchange rate is stable. 3. Historical experience suggests that fixed/pegged exchange rate systems are difficult to sustain. –In the last decade, many major countries like Thailand, Indonesia, S. Korea, Brazil, and Argentina have changed their system from fixed to floating. –Amongst the major nations, exceptions are Malaysia and China.

Evaluating the Floating Exchange Rate System 1. The domestic policy can be conducted independently of the exchange rate, for the most part. This may be good or bad. –Typically, the Central Bank focuses on domestic policy, ignoring exchange rate fluctuation.e.g. Greenspan worries about inflation and unemployment, but rarely talks of exchange rates. –However, if domestic policies are not effectively managed, you can have a severely depreciating currency, creating a crisis (through high inflation and interest rates). 2. Exchange rate volatility increases risk. This risk has to be managed, and is costly. –In particular, foreigners investing in the country will want a “risk premium” to account for currency risk. –The development of the f/x derivative markets in the US and Europe are a direct consequence of the floating rate systems.

Evaluating the Currency Board System 1. There is limited role for domestic policy. For example, the Central Bank has no role to play in fixing money supply, or affecting exchange rates. 2. It links the domestic economy to the country that the currency is linked to. Thus, interest rates and inflation will be largely decided by the domestic policy of the foreign country. –Something to think about: Why was Argentina forced to devalue?

Where to download historical f/x data?